Trim government to empower the Chinese: Andy Xie

Productivity can only rise if market forces allowed to operate

AndyXie

BEIJING (Caixin Online) — Two powerful forces have driven China’s growth in the past decade. A favorable demographic trend has cut China’s dependency ratio to one of the lowest in modern history.

China’s baby boomers were born between 1950 and 1975. The one-child policy of the past three decades has amplified the natural demographic trend, making today’s dependency ratio — which the World Bank defines as the ratio of dependents (people younger than 15 or older than 64) to the working-age population — unusually low.

Also, the labor participation rate of China’s women is similar to men’s. It is partly due to low household wealth. That force may be reversing too. From now onward the dependency ratio is likely to rise. The demographic tailwind is turning into a headwind.

After China joined the World Trade Organization a decade ago, multinational companies shifted production to China from Europe, Japan and the United States.

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The redistribution of manufacturing capacity triggered a surge in China’s share of global trade. This tailwind is responsible for the rapid growth in bank deposits and money supply. The fixed exchange rate amplified the impact of trade boom on money supply.

The debt crises in the West signal the end of China’s trade boom. When their factories moved to China, these countries resorted to debt to sustain their living standards. As long as the market was willing to go along, the debt-driven consumption continued, which in turn fed China’s export boom. As the debt bubbles burst, so did spending power. This is why China’s export boom is over.

The good, the bad, the ugly

A favorable demographic trend doesn’t automatically turn into economic growth. Most Latin American countries missed the opportunity. India could do the same.

East Asian economies like Japan, South Korea and Taiwan experienced similar forces before and successfully seized the opportunity. China has followed the East Asian model and experienced similar successes as well as similar problems.

Whenever money is plentiful, wasteful spending is inevitable. In the 1920s, U.S. businesses over-invested in new technologies and this led to massive overcapacity, which precipitated the Great Depression. In the 1980s Japanese businesses over-invested too and paid too much for trophy assets abroad. Its economy has stagnated for two decades. China has done the same. Over-capacity is everywhere. The overall overcapacity could be one-third, much greater than either in the United States at the end of the 1920s or in Japan in 1992.

The WTO and demographic tailwinds meant strong monetary growth. China used part of the money to build up a supporting infrastructure for manufacturing successes. Transportation, energy and telecom systems have become highly developed.

Multinational companies can operate in China as in developed economies while enjoying low labor costs. The competence in building infrastructure made it possible for the economy to benefit from joining the WTO and its favorable demographic trend.

Exports rose by 20% per annum in the decade after joining the WTO, which catapulted the country to the No. 1 spot in global trade.

Whenever money is plentiful, wasteful spending is inevitable. In the 1920s, U.S. businesses over-invested in new technologies and this led to massive overcapacity, which precipitated the Great Depression. In the 1980s Japanese businesses over-invested too and paid too much for trophy assets abroad. Its economy has stagnated for two decades.

China has done the same. Over-capacity is everywhere. The overall overcapacity could be one-third, much greater than either in the United States at the end of the 1920s or in Japan in 1992.

Easy money usually leads to speculation, asset bubbles, and corruption or rent-seeking. China’s stock market rose five times between 2005 and 2007. The land price rose over thirty times in the boom decade. In some cities, it went up 100 times. The asset bubbles amplified the feeling that money was easy to come by, which decreased resistance to wasteful investment or rent-seeking activities.

Like in the United States and Japan before, the bubbles functioned partly to subsidize investment.

For example, China’s stock market has declined in the past decade even though the nominal gross domestic product rose four times. Japan’s stock market is as low as three decades ago. After the 1929 crash, the U.S. stock market didn’t reclaim its peak for two decades.

China’s fixed investment has been close to half of GDP for many years, much higher than Japan’s or the United States’ during their peak years. It suggests that China’s challenges would be as severe as what the United States faced in the 1930s or Japan in the past two decades.

The turning point

The East Asian development model is investment and export-led. The investment boom is made possible by the export boom because over-investment requires excess liquidity from exports. Hence, if the export boom ends, the investment boom is certainly ending. The limiting condition is the exchange rate.

During the boom, the fixed exchange rate turned the export boom into a monetary boom. It does the same on the way down. If the domestic political system insists on pushing investment despite export stagnation, it would lead to a currency collapse. This occurred to South Korea and Thailand in 1997.

Southeast Asia, South Korea and Taiwan lost their export booms because China became more competitive. China’s export boom is ending because its customers face bankruptcy. This is a unique situation because China is so big relative to the world.

In terms of per capita income or exports per person, China’s levels are less than half of the levels when South Korea and Taiwan faced a similar challenge.

China’s exports rose twice as fast as global trade and four times the global economy in the past decade. The chances are that exports would rise less than 10% in the coming decade. That would require China to scale back investment to below 30% of GDP.

The most important part of the turning point is land prices going into a down channel. While many cite statistics and anecdotes to support the property bubble continuing, the facts on the ground are that it is deflating.

In some cities, the property market has collapsed. In most cities the prices have dropped significantly. Unlike the stock market, the property market takes time to adjust, possibly five to six years; 2012 is the first year. When it’s all over, the price of land could drop by 80% in many cities and property prices by half.

The long-term future of China’s property market is extremely dire. In addition to a price bubble, China has an unprecedented quantity bubble. Further, the demographic burst is less than ten years away. All these factors point to a property burst as big as in Japan or Taiwan.

Paying for the past

Waste and bubbles are inevitable during an economic boom. When it’s over, paying for the past mistakes can be quite complicated. In particular, asset quality in the banking system deteriorates sharply after a boom. Because banking asset quality could be hidden, the problem may be covered up for many years.

The problem came out in Southeast Asia because the region faced a liquidity crisis. Japan kept its bad loans under the rug for six years after the property bubble began to deflate because its banking system didn’t face a liquidity problem. Japan chose to cut investment to sustain its banking liquidity.

China’s non-financial sector debt is over two times GDP. It doesn’t include underground lending. If that is included, the level could be 2.5 times. This is very high for a developing country.

Mature economies have non-financial sector debt of 2-2.5 times GDP. They could have such levels of debt because their household wealth levels are higher. At China’s $6,000 per capita income level, no other countries could be found with the same debt level, including the East Asian economies, when they went into debt crises in 1997.

China’s debt is skewed toward businesses and local governments. Mature economies tend to have 50% to 70% of GDP in business debt. China’s is twice as high. Moreover, China’s business profitability is about half of the global average. It means that the debt burden is four times. This is why China’s stock market is so weak despite the economic boom. This is China’s Achilles’ heel.

The business debt is not comparable to its earnings capacity. It will inevitably lead to large amounts of bad loans.

In the past, the problem was covered by appreciating land prices, which empowered local governments to subsidize businesses. The businesses could borrow more on appreciating land value to stay liquid. As the land market reverses, the problem becomes exposed. It requires the government to deal with the ban loans as soon as possible. Otherwise, the banking system could freeze up for years.

Growth potential

Even though the twin dividends are over, China still has plenty of growth potential. The current per capita income is one-seventh of the level in developed economies. China’s relative income was probably higher towards the end of the 1930s.

Considering that ethnic Chinese are among high-income groups in developed economies, it doesn’t make sense for China’s income to be so low relative to the world. If so, it means that the country’s system, not the people, is the problem.

China’s debt is skewed toward businesses and local governments. Mature economies tend to have 50% to 70% of GDP in business debt. China’s is twice as high. Moreover, China’s business profitability is about half of the global average. It means that the debt burden is four times. This is why China’s stock market is so weak despite the economic boom. This is China’s Achilles’ heel.

The recent debates on the growth potential tend to focus on the wrong areas. Many try to bring up the demographic dividend again, ignoring the fact that few people in their prime remain in villages. Urbanization is resuscitated as another growth area.

But, most tier-three cities are overbuilt. Their properties under construction would take many years to absorb. The discussion on where to find growth reflects arrogance on its participants. Economic growth ultimately comes from a productivity increase, not investment per se or more workers.

Productivity growth depends on constant optimization of capital and labor by market forces. The price mechanism is the greatest human invention. It turns collective wisdom into improving productivity.

If a few people can identify where growth comes from in the second largest economy in the world, they would surely be much smarter than Warren Buffett.

If they are, they would be making billions for themselves rather than working for the government or think tanks. The people who talk about where the economy could grow in future don’t know what they are saying. If they are put in positions of decision-making, they would do great harm to the country.

Shrinking government

An expanding government is the root cause for many economic ills in China. More people in the government means more pressure for rent-seeking. As administrative power, not the rule of law, dominates the economy, rent-seeking pressure inevitably changes the economic structure into one for its convenience.

Making bubbles, building image projects, and increasing taxes and fees on the people are some of the inevitable consequences. As long as the government remains so large, the pressure for bringing to it more money always exists. If one tax is cut, another one may come to replace it.

The beginning of the property bubble deflating is decreasing government revenue, as land sales revenue drops. This is the main reason behind the push for a property tax.

While a property tax is appropriate under certain conditions, they don’t exist in China. For example, a property tax should occur if property is really owned. China’s property titles are for 70-year usage.

Second, property tax revenue should go into local usage like education. China’s property tax is likely to support existing government spending in investment. Some argue that the tax is for controlling speculation. That is not correct. The right tool for controlling speculation is a capital gains tax.

There is one already. If it is not enough, it could be raised. The real purpose of the property tax is to feed the government.

This is why China’s economic reforms are unlikely to succeed without changing the governing structure. The most important benchmark is in the number of people in the administrative system.

Many government agencies have seen their payrolls increasing by ten times in the past fifteen years. To make the government effective and constructive, the size of government needs to be cut by half or more. This is obviously difficult to achieve, but China’s future depends on it.

In the short term, the government could cap its expenditures to the current levels for five years. Also, state-owned enterprises (SOEs) should cap their investment for the same period. As long as these objectives are met, the government sector would shrink relative to the economy, making it more efficient over time.

Purchasing power to the people

China’s household consumption is about one-third of GDP. It is low because labor income accounts for just over 40% of GDP. Gray income is probably 10% of GDP.

Most money in China goes to the government and SOEs. Companies go to them for demand and profit. As their spending is not efficiency-driven, their suppliers are not either. This is why, even though China is the second-largest economy in the world, it doesn’t have many competitive companies to speak of.

Efficient companies rise when they meet sustainable and efficient demand. When money is spent by the people for their needs, the demand created is sustainable. Companies that compete for it successfully will last.

China’s household consumption should be above 50% of GDP, similar to that in other developing countries. It requires labor income at 65% of GDP, also a normal level.

These goals can only be met if the government and SOE’s share in the economy decreases. In the short term, the government could cut income and consumption taxes by 1 trillion yuan ($160 billion)
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Such a down payment could increase demand for industries with overcapacity and boost market confidence in China’s future.

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